Wednesday, 11 September 2013

Managing expectations as part of monetary policy

In trying to ease
concerns about higher interest rates through forward guidance, central banks
have ended up doing the opposite.

Managing expectations when you work with people in an office
environment can be tough but imagine dealing with the multitude of global
investors as well as the international press.
This is what central banks have to cope with. Central banks have tried to provide greater
clarity regarding the direction of monetary policy using forward guidance –
linking changes in policy to improvements in economic data. The plan was to ease concerns that monetary
policy would be tightened too soon through fewer bond purchases and eventually
higher interest rates. But forward
guidance instead triggered the selling of government bonds with investors now
expecting tightening of monetary policy sooner than central banks are
suggesting. Why have investors reacted
in this way and what might central banks do in return?

A change in monetary policy was always going to be a tricky
proposition considering the influence that the central banks have built up over
the markets due to their purchases of billions in bonds as part of quantitative
easing (refer to Caution - Windy Road Ahead). It all started with a statement by the
Federal Reserve in the US in June that it was considering tapering off its bond
purchases which currently amount to US$85 billion. Any new policy initiatives in the US are
predicated on the pledge by the Federal Reserve that interest rates will remain
at their current low levels until there is substantial improvement in the
labour market. This is one version of
forward guidance that has also been adapted by Mark Carney, the new governor of
the Bank of England, who also linked future decisions on monetary policy to the
unemployment rate in the UK (for more, see Same low interest rates but for longer). The reasoning behind
forward guidance is twofold – to assure potential borrowers that interest rates
will stay low for a few years yet and to placate fears that tightening of
monetary policy will hurt the nascent economic recovery.

Not much of a market reaction was expected from these
announcements as central banks were signalling that changes to the status quo
would be gradual depending on the state of the economy. However, investors have reacted in a way that
seems to suggest that tightening of monetary policy is imminent, that is, by
selling off government bonds. The
interest rates on government bonds have risen from record lows and 10-year
bonds issued by the US and UK governments have both reached close to 3% (lower
bond prices due to selling results in higher interest rates on bonds). Why did the markets respond in this way to
seemingly innocuous comments?

Cautious investors had been big buyers of safe assets such
as UK and US government bonds due to the weak state of the global economy
coupled with the sovereign debt problems in Europe. This had capped off a period where bond
prices had followed an upward trend for a few decades, which is a long time in
investment markets. Higher bond prices
had pushed interest rates to painfully low levels so the timing was ripe for
investors to move their money somewhere else.
All that was needed was a trigger and this ended up being the statements
on forward guidance. It is as if the
mere mention of the end of the current loose monetary policy got investors
thinking that a bond sell-off was coming and that it would be better to beat
the rush.

For holders of UK government bonds, data on the economy has
added to the reasons to sell. The OECD
released economic forecasts in early September which predicted that the
recovery in the UK would pick up pace faster than in other countries. A potential housing bubble in the UK adds to
concerns that the Bank of England will have to increase interest rates earlier
than planned. Mark Carney also left
plenty of escape clauses in the forward guidance pledges which allows the
central bank the freedom to act but gives rise to worries that interest rates
will not stay low for as long as has been suggested.

The rebellion of the markets against the careful planning of
the central banks does throw up a few issues.
Considering that both the US and UK have mountains of government debt,
higher interest rates will translate through to greater limitations on
government spending which, in turn, will hurt the economy. The fortunes of the global economy have also
taken a hit with higher returns on bonds prompting investors to repatriate
money invested in emerging markets over the past few years when there were few
other investment options. But the rush
of money leaving places such as India and Turkey has brought howls of protest as
well as fears about the ramifications of the end of quantitative easing on
international finance.

It is central banks that now have to make the next
move. Yet this could involve doing
nothing. The tightening of monetary
policy was never going to be easy and the recent jumpiness of investors could
be just seen as collateral damage. This
would be a prudent option if central banks believe that there is nothing else
that they could do to dictate the directions of the market. But, on the other hand, central banks may
decide to wrest back control of the expectations of investors. Such a course of action could be prompted by
fears that interest rates on government bonds, which act as a benchmark for
interest rates throughout the whole economy, are too high at a time when the
economic recovery is just starting in earnest.
Since forward guidance has shown that mere words are not enough, central
banks may have to act, possibly with more bond buying. Such a shock would bring investors back into
line and serve as a reminder not to second-guess central banks. However, with central banks likely to be
keener to step out of the limelight (for What's the rush?), investors are likely to be left to their own devices.